Rhode Island Crisis Raises Issues on Federal Regulation

The financial panic that has hit small banks, credit unions and other financial institutions in Rhode Island is raising a serious question about federal regulation of the nation’s troubled financial system:

Why have federal regulators allowed non-federally insured institutions to remain in existence years after it became clear that they were too weak to survive in the increasingly volatile financial marketplace?

The breakdown in Rhode Island isn’t the first time that these institutions have proved unreliable. Five years ago, financial mismanagement sparked runs on privately insured banks and savings and loans in Ohio and Maryland that eventually led to statewide banking holidays.

Small depositors were unable to withdraw their funds, and some actually lost money. Banking experts warned then of the dangers of allowing small, private deposit-insurance funds to continue when they clearly didn’t have the resources to provide adequate backing.

This month, history is repeating itself. Rhode Island’s governor has been forced to declare a banking holiday, depositors’ accounts are frozen and banking experts say the state could be plunged into a fiscal crisis if it ends up having to bail out depositors in some institutions.

To many financial analysts, the Rhode Island crisis has pointed out a gaping hole in the nation’s financial safety net. “It’s amazing that no one has done anything about this,” says Robert Litan, a Brookings Institution banking specialist.

Yet, Litan and others who are familiar with the sentiment of top policy-makers here concede that almost no one in Washington seems prepared to do anything to correct the situation.

Congress and federal regulators have never seriously attempted to force locally insured institutions to apply for federal insurance--a step that would force them to follow some minimum standards for capitalization and management and help bring them into line.

Indeed, it was a powerful Democratic congressman from Rhode Island--former House Banking Committee Chairman Fernand J. St Germain--who blocked efforts in the mid-1980s to require privately insured institutions to apply for federal coverage.

Even the broad reform measures that Congress has passed to deal with the crisis in the S&L; industry have not addressed the private insurance issue.

Nor have successive Democratic and Republican administrations sought to put an end to private insurance. Instead, policy-makers have tended to dismiss the issue as a state or local problem.

As late as this week, a spokesman for the Federal Deposit Insurance Corp. said that the agency was seeking to keep a “low profile” during the Rhode Island crisis, adding that the FDIC had no plans to assume the losses of any Rhode Island institutions that fail.

“People have been remarkably blase about this” in Congress, a congressional strategist admits.

“It must be inertia,” Litan concludes. “Unless there is a crisis, nobody does anything about a problem,” he says.

To be sure, many state governments did move--in the wake of the panics in Ohio and Maryland--to force privately insured institutions under the federal umbrella. Today, only a handful of banks and thrifts--notably in Rhode Island and Pennsylvania--are outside the system.

But regulators warn that credit unions now pose a far more troubling problem than do the banks.

Federal credit union regulators conceded this week that until the Rhode Island crisis highlighted the issue, they did not even know how many credit unions around the country were not covered by federal deposit insurance.

Now, they concede that roughly 10% of the nation’s credit unions are not covered by federal insurance.

“We were surprised by the numbers--we thought that about 97% of credit unions were under federal insurance,” concedes Sue Nelowet, a strategist at the National Credit Union Administration, the federal agency charged with regulating credit unions.

Credit unions that agree to federal regulation by the NCUA receive deposit insurance through the National Credit Union Share Insurance Fund, which now has $2.1 billion in reserves and is the credit union counterpart to the bank insurance fund run by the FDIC.

But even though many of the institutions caught up in the Rhode Island crisis are credit unions, officials say the credit union industry is likely to fend off any attempt to force them to accept federal insurance.

Moreover, the credit unions have one of the strongest lobbies of any financial industry in Washington, and have been conspicuously successful in fighting off increased regulation.

Early last year, for example, the industry succeeded in killing a proposed provision in the savings and loan reform legislation that would have called for increased regulatory oversight of credit unions.

“In the credit union community, there is a strong feeling that they like to run themselves, they want to be free from what they view as onerous federal regulation,” Nelowet says. They see their insurance coverage “as a state issue,” she adds.

Nevertheless, analysts say, at a time when the nation is already faced with the most severe crisis in the financial industry since the Great Depression, it may be difficult for the system to take the strain of further panic involving privately insured institutions.

“I’ve warned people for years that this kind of thing could happen again,” says Bert Ely, a Washington-based savings and loan consultant. “And here it is, happening again.”